Monday, 7 October 2013

Nigeria: Who Guards the Guardians

OPINION

Last week, I was concerned with how much the Central Bank of Nigeria's (CBN) recent measures for managing the demand for and supply of foreign exchange speak to a macroeconomic emergency in the country. On reflection, however (and after long palavers with those who ought to know better), it would seem that even the CBN itself is rapidly becoming a vulnerability -- to paraphrase the regulator, even the apex bank may now pose a strong "systemic risk".

Amongst the CBN's principal objects are the promotion of "a sound financial system in Nigeria"; and acting as banker and providing "economic and financial advice to the Federal Government". If the central bank is to fulfill this "lender of last resort" role on an ongoing basis, it is only logical that it must have a balance sheet liquid enough to backstop crisis anywhere in the financial sector. Indeed, it ought to be able to backstop potential seizures across the economy (to the extent provided for by the Fiscal Responsibility Act), and within the conceptual framework recently elaborated by central banks' interventions around the world in response to the challenges of the Great Recession.

The question (raised by a friend only recently), and which then adverted my attention to the possible threats to the economy from the operations of the apex bank, is: "as is, is the CBN's balance sheet liquid enough to help it hold off any such crisis?"

The suspicion, or rather, the conclusion from my discussions all of last week around this subject, is that the answer to this is a "no"! "On what evidence?" you might ask. There is no better place to commence searching for substantiation than the foreign exchange market (around which, incidentally, my piece last week was written).

As at Wednesday, last week, the balance on Nigeria's external reserves stood at US$45.39bn (30-day moving average with effect from November 2011), about 22% of which is locked in. That is, the CBN may not have recourse to this portion of the reserves.

Current estimates of foreign portfolio inflows into the economy range from anywhere between US18bn and US$20bn. Now, this is the most fickle part of the economy. It spooks easily (as was readily demonstrated following its reaction to the May speech by the Chairman of the US Federal Reserve in which he alluded to the possibility of a tapering of the programme of quantitative easing).

Yet it is perhaps the most important right now. Much of the recovery in the domestic equity market is attributable to about 45% of the FPI flow ending up in stock purchases. Thus, were this funds persuaded to leave, the stock exchange could once again go belly-up. However, more crucial is the potential effect on the demand side of the foreign exchange market where these funds to take flight. If we estimate returns on the equity side of these investments at about 30% (not worrying about the tenor), a rush for the exit will find the CBN having to cope with demand for about US26bn. It is hard to imagine attending to this need without seriously depleting the reserves, or hurting the naira.

Add to this (or back out from, if you will), the cost of the CBN meeting its short-term obligations (treasury bills and open market operations) arising this year (estimated at a little over US$9bn), and you have the makings of a crisis. The CBN may not have enough in its coffers to deal with a major foreign exchange crisis; at a time we seem to have the makings of another crisis in the financial services sector on our hands.

To its credit, it moved quickly to contain the fallout from the implosion of Consolidated Discount House Limited. By pledging to pay back the depositors' principal held with the discount house, it prevented a run on discount houses, and the collateral pressure on the interbank market. However, the country's discount houses face a dilemma worse than the dinosaurs faced from the ice age.

We could argue that they were always fringe players, and so the systemic damage to the financial services industry is well contained. Part of the problem is that such interventions have multiplied the value of the asset side of the CBN's balance sheet. Another part of the problem is that these assets are nearly all dud, the result of the apex bank's earlier activity in support of the banking sector.

Which is the more frightening prospect here? The fact that the CBN may not be able to make good on the long term investments on its balance sheet, or the fact that these investments are financed through short-term liabilities?